Reference no: EM133039459

If an American hotel company which produces its annual results in its home currency, US dollars, purchases a hotel in Australia, it acquires an asset (the hotel) which is priced in the local currency, Australian dollars (AU$).

Each year when the balance sheet of the business is prepared, the value of the hotel would be translated into the company's 'home' currency (in this case, US dollars) at the prevailing rate on the balance sheet date. The risk is that the hotel might therefore be worth less in US dollar terms, as shown on the balance sheet of the company, than the cost of the asset when it was bought. This would be the case if the Australian dollar were to rise against the US dollar.

For instance:

the company purchased the hotel when the US dollar/Australian dollar rate was 1.10 (i.e., 1 US dollar buys 1.10 Australian dollars); and

the hotel cost AU$10 million.

In this case, the planned cost in US dollars to the company would be AU$10,000,000/1.10 = US$ 9,090,909. This is the value of the property which will be recorded at the time of purchase..

If the rate of the Australian dollar subsequently strengthened and the exchange rate changed to $1.15, the value of the property, recorded in the annual report in US dollars, would fall to 10,000,000/1.15 = 8,695,652, a recorded drop in value of over us$395,000, which would be recorded in the annual accounts.

Questions

1. What would be the impact if the hotel company took out a loan of AU$10 million to pay for the hotel?

2. Explain why, if a country's currency is historically very volatile, it might deter investment in physical assets such as hotels in that country.

Economic exposure

2) Economic exposure (sometimes referred to as political exposure) arises from the effect of adverse exchange rate movements on future cash flows, where no contractual arrangement to receive or pay money has yet been made.

This kind of exposure is longer term in nature and often difficult to quantify exactly and forecast accurately. It is illustrated by the following case of a specialist tour operator.

Short Case Illustration

Economic exposure: a European specialist tour operator

Suppose a specialist European tour operator operates most of its program to one country - say, Egypt. The company will have an economic exposure to that country and its currency.

In some cases, the political and economic circumstances are very uncertain. if, for example, the government should be replaced in a violent way, as occurred in recent years in Egypt, customers will be reluctant to book holidays to that country, thereby severely limiting the revenues of the specialist tour operator.

Questions

1. What steps might the company as described here take to protect itself against economic risks?

2.What other examples of economic risk affecting THE organizations you are familiar with could you cite?